Welcome to S Corporations!
Hello future CPAs! Today we are diving into S Corporations. If you have already studied C Corporations and Partnerships, you will find that S Corps are like a "hybrid" of the two. They offer the legal protection of a corporation but the "flow-through" tax benefits of a partnership. This is a high-yield topic for the REG exam, so let’s break it down into simple, bite-sized pieces. Don't worry if it seems like a lot of rules at first—we will take it one step at a time!
1. What is an S Corporation? (The "Exclusive Club")
Think of an S Corp as a regular corporation that has asked the IRS for a special "tax status." Instead of the corporation paying taxes (double taxation), the income "flows through" to the shareholders, who report it on their personal tax returns.
Eligibility Requirements
To be an S Corp, you must meet strict rules. I like to call this the "100 Citizens with One Stock" rule:
• Shareholder Limit: No more than 100 shareholders. (Note: Family members, like spouses, parents, and kids, count as one shareholder!)
• Eligible Shareholders: Must be individuals, estates, or certain trusts. Important: Corporations and Partnerships cannot be shareholders.
• Residency: Shareholders must be U.S. citizens or residents (no non-resident aliens).
• One Class of Stock: You can have different voting rights (voting vs. non-voting), but the distribution and liquidation rights must be the same for everyone.
Making the Election (Form 2553)
To become an S Corp, all shareholders must consent.
The Deadline Rule: If you want the election to count for the current year, you must file by March 15th (for calendar year taxpayers). If you file on March 16th, you are stuck as a C Corp for the rest of the year, and the S Corp status starts next year.
Quick Review: To be an S Corp, you need 100 or fewer "human" U.S. shareholders and only one class of stock. Everyone must agree to the election by March 15th for it to count this year.
2. S Corp Operations: How Income Flows Through
Just like a partnership, an S Corp is a flow-through entity. It files an information return (Form 1120-S) and provides each shareholder with a Schedule K-1.
Ordinary Income vs. Separately Stated Items
Imagine a suitcase. Some items (like ordinary business income) get thrown into the main compartment. Other items (like charitable contributions or capital gains) need their own special side pockets because they are treated differently on an individual's tax return.
Ordinary Business Income: Sales revenue minus standard operating expenses (rent, utilities, employee wages).
Separately Stated Items: These are items that might affect shareholders differently based on their personal tax situation. They include:
• Rental income/loss
• Interest and Dividend income
• Capital Gains and Losses
• Section 179 deductions
• Charitable contributions
Common Mistake Alert: Shareholders do not pay self-employment tax on their share of S Corp ordinary income. This is a huge difference from partnerships! However, if a shareholder is also an employee, they must be paid a "reasonable salary," which is subject to payroll taxes.
Key Takeaway: Income flows to shareholders based on their percentage of ownership on a per-share, per-day basis. If you own 50% of the stock for the whole year, you get 50% of the profit.
3. The "Golden Rule" of Basis
Basis is one of the most important concepts for the REG exam. It tracks how much "after-tax" money you have in the company. It limits how much loss you can deduct and how much money you can take out tax-free.
Calculating Shareholder Basis (The Formula)
\( \text{Initial Basis} \)
\( + \text{Additional Contributions} \)
\( + \text{Share of ALL Income (Taxable and Tax-Exempt)} \)
\( - \text{Distributions to Shareholders} \)
\( - \text{Share of Non-deductible Expenses} \)
\( - \text{Share of Losses} \)
\( = \text{Ending Basis} \)
Did you know? Tax-exempt income (like proceeds from a life insurance policy) increases your basis. Even though you don't pay tax on it, it increases your "investment" in the company!
The Debt Basis Rule (Crucial for the Exam!)
In a partnership, your basis includes your share of company debt. In an S Corp, it does NOT.
A shareholder only gets "debt basis" if they personally lend money directly to the corporation. If the bank lends money to the S Corp, the shareholder gets zero basis increase, even if they personally guarantee the loan.
Memory Aid: "S" stands for "S Corp" and "Self-Lent." You only get debt basis if you lent it yourself!
4. Distributions: When is the Cash Taxable?
This depends on whether the S Corp was always an S Corp or if it used to be a C Corp.
Scenario A: S Corp has no "Accumulated Earnings & Profits" (Always an S Corp)
1. Distributions are Tax-Free to the extent of stock basis (Return of capital).
2. Distributions in excess of basis are Capital Gains.
Scenario B: S Corp has "Accumulated Earnings & Profits" (Used to be a C Corp)
When a C Corp becomes an S Corp, it brings its "old baggage" (Earnings & Profits) with it. We use a specific order (the "Layers of the Cake"):
1. Accumulated Adjustments Account (AAA): This is S Corp profit that hasn't been distributed yet. Tax-free.
2. Accumulated Earnings & Profits (AEP): This is old C Corp profit. Taxed as a Dividend.
3. Return of Stock Basis: Tax-free.
4. Excess: Capital Gain.
Quick Review: If the S Corp was always an S Corp, it's easy: Basis = Tax-free; over basis = Capital Gain. If it was a C Corp, look for the "AAA" first!
5. Terminating the S Corp Status
How does the "exclusive club" membership end? It can happen in three ways:
1. Voluntary Revocation: Shareholders holding more than 50% of the stock agree to quit.
2. Failure to Meet Eligibility: For example, you accidentally sell stock to a corporation or a 101st person. The status ends immediately on that day.
3. Passive Income Penalty: If the S Corp has old C Corp E&P AND more than 25% of its gross receipts are passive (like interest/dividends) for three consecutive years, the status is lost on the start of the fourth year.
The Waiting Period: Once the election is terminated, the corporation must wait 5 years before it can re-elect S Corp status unless the IRS grants special permission.
Summary: S Corporations provide a powerful way to avoid double taxation. Remember the 100-shareholder rule, the direct-loan rule for debt basis, and the "AAA before E&P" rule for distributions, and you will be well on your way to mastering this section of the REG exam! You've got this!